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Finance and Growth: When Credit Helps, and When It Hinders

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Finance and Growth: When Credit Helps, and When It Hinders Session “Socially Useful Financial Systems” Bezemer – ‘When Credit Helps, and When it Hinders’ Finance and Growth: When Credit Helps, and When it Hinders Dirk J Bezemer, University Groningen ([email protected] ) EXTENDED SUMMARY The financial sector can support growth but it can also cause crisis. The present crisis has exposed gaps in economists’ understanding of this dual potential. This paper grounds an alternative approach in the credit nature of money, and in an older distinction between credit flows that grow the economy of goods and services (the GDP), and credit that inflates markets for financial assets and property. This increases the debt-to-GDP ratio and can be a helpful catalyst of the real sector. But if it overshoots, it leads to bloated financial markets and the pursuit of capital gains rather than profit, with rising costs due to high asset values, rising inequality, falling fixed capital formation, rising uncertainty, and fraud and corruption. Unfortunately, overshooting is built into the system due to the nature of money, banking and compound interest. That is why financial deregulation leads to credit booms and busts. A return to financially sustainable growth in the longer term requires a shrinking of the mortgage, consumer credit and nonbank financial sector which is a creditor to the real sector, and absorbs a continuing flow of liquidity in interest payment and financial fees that would otherwise be effective demand for goods and services, supporting economic growth. Financial deregulation has allowed the US ‘FIRE’ sector to grow to about three times the size it had in the 1980s and so its claims on the real sector are three times larger than a quarter century ago. This is unsustainable, but present policies are to sustain it by supporting the financial sector, even more than supporting the economy. Instead, we need consistent de-financialization policies: less is more, in our situation. And given finance’s built-in expansionary drive, achieving freedom from the rule of capital gains requires restraining regulation: no liberty without law. 1 Session “Socially Useful Financial Systems” Bezemer – ‘When Credit Helps, and When it Hinders’ Finance and Growth: When Credit Helps, and When it Hinders Dirk J Bezemer, University Groningen ([email protected] ) In der Beschränking zeigt sich erst der Meister (less is more) Und das Gesetz nur kann uns Freiheit geben (no liberty without law) J.W. von Goethe (1802) 1. Introduction This paper is part of a conference session addressing the question “how can we create a financial system that is socially useful?”. When James Tobin in his 1984 Hirsch Memorial Lecture spoke "On the Efficiency of the Financial System", he disparaged that “… we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity.” It is sobering to realize that he said this when the stock of outstanding credit in the US supporting such activities – mortgages, consumer lending, and all sorts of financial investments - , was only a third of its present size, relative to GDP (not even counting the shadow banking sector). Tobin’s hunch was that what undermines the social usefulness of the credit system is precisely this trend. This paper develops an analytical and historical underpinning of the ‘Tobin Conjecture’. 2 Session “Socially Useful Financial Systems” Bezemer – ‘When Credit Helps, and When it Hinders’ An uncontroversial starting point is that the financial sector can support growth but it can also cause crisis. The present crisis has exposed gaps in economists’ understanding of this dual potential, and in this sense it is a paradigm test (Bezemer 2011). Current macroeconomic models do not distinguish between credit flows that help and those that hinder the economy and they ignore the role of debt stocks (Godley and Lavoie 2006). It is as if all credit supports growth with no risk of crisis, and as if levels of debt are irrelevant when assessing if further debt growth is helpful or harmful. In this paper both these problems are addressed by tracing credit flows and their different impacts on the economy’s debt burden which, in turn, affects key socio-economic indicators such as productivity and equality. Is this new? The question may arise since stated in its simplest form, a credit- focused approach seems to spell out the obvious. It is that finance is both credit and debt, that both these sides of the financial process need to be traced; and that different financial flows have different impacts with regard to credit and its ‘dark side’, debt. For instance, prolonged booms in mortgage flows and consumer lending tend to create larger net debt burdens than lending to nonfinancial business. Non-economists may assume that money, debt and credit flows, and the different effects they may have, are at the heart of macroeconomic models. Economists will appreciate that to take this as a starting point is a radical difference with today’s mainstream thinking. For instance, while most non- economists would agree that a financial crisis can be deeply traumatizing to the economy, Bernanke already in 1983 already wrote that “only the older writers seemed to take the disruptive impact of financial breakdown for granted” (1983:258). That impact has since been vanishing from economists’ collective memory, until very recently. It is no coincidence that in the same quarter century, DSGE models (which by design exclude the tracing of financial flows and of debt) rose to prominence. The type of macroeconomics they represent cannot, in principle, help us understand either credit’s growth effects, or its capacity to precipitate crisis. It is important to explain this, since it implies the need for an alternative (though not a brand new) discourse on credit, growth and instability – a discourse started by the Classical economists, especially Marx, 3 Session “Socially Useful Financial Systems” Bezemer – ‘When Credit Helps, and When it Hinders’ continued by Keynes, Schumpeter and Minsky, and sidelined over the last decades. The implications of its seemingly simple starting point are not all that obvious, nor is the surprisingly wide array of applications. This is new thinking based on old principles. The paper proceeds as follows. In the next section ‘state of the art’ macroeconomics is discussed, and why it has had such a hard time addressing the question implied in the title of this paper. Section three turns from models to reality, to show that historically, money emerged as one form of credit. This is relevant as the credit nature of money still defines the impact that money has on the economy. In section four, that distinction is made operational, both in concept and in measurement. This shows that credit to the nonfinancial business sector (‘real-sector credit’ for short) is equal to GDP growth, while an economy’s net build-up of debt – the cause of financial fragility and instability - is due to an increase in credit flowing to the finance, insurance and real estate sectors – or ‘financial-sector credit’. Marx, Schumpeter, Keynes and Minsky, and in our time Tobin (1984), Godley (1999), Werner (1997), Hudson (2006), Keen (2011) and others have written on this important distinction, but mainstream macroeconomics is still to incorporate it. Sections five and six introduce empirical measures and a stylized flow chart model, and section seven discusses what the optimal level of credit to the economy is, and when there is ‘too much finance’. The answer is fairly straightforward in principle. Section eight show that in practice things are not so simple, in an examination of the diverse way in which excessive growth of financial-sector credit may hinder rather than help economic growth, even as it fuels booms in wealth and consumption. Amidst this diversity, it is emphasized how at the heart of each credit boom gone wrong is the inability (or refusal) to make the distinction between real-sector and financial-sector credit flows. Section nine concludes with a summary and conclusions. We need to shrink the debt overhead. This will happen in any case, but the choice is whether to do this by overall deleveraging and prolonged recession, or by targeted and time-honoured regulation that reduces the economy’s debt to the property and nonbank financial sector. 4 Session “Socially Useful Financial Systems” Bezemer – ‘When Credit Helps, and When it Hinders’ 2. A Problem With ‘State of the Art’ Macroeconomics The state of the art of today’s macroeconomics is expressed in the ‘Dynamic Stochastic General Equilibrium’ (or DSGE) family of models. They ‘have become very popular in macroeconomics over the past 25 years. They are taught in virtually every Ph.D. program and represent a significant share of publications in macroeconomics.’ (An and Schorfheide 2007:113), and they are widely used in policy analyses in international institutions and central banks – see, for instance, introductions to the DSGE model used by the IMF (Botman et al, 2007), the European Central Bank (Smets and Wouters, 2003) or the Reserve Bank of New Zealand (Lees, 2009). Given their predominance at the time of the crisis, DSGE models have come in for vocal criticism from within the profession (e.g. Buiter (2009) and Solow (2010). The problem in the present context is that DSGE models are characterized by the “absence of an appropriate way of modeling financial markets” (Tovar 2008:29). And what is true for DSGE models is true for macroeconomics in general, and has been for a long time. Schumpeter (1934:95) already noted that “processes in terms of means of payment are not merely reflexes of processes in terms of goods.
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